Reading the Oil Leaves

Friday Reflection

Reading the Oil Leaves

This week saw stock and bond prices end relatively flat, with lower trends early in the week as Gilead’s vaccine trials stumbled, but recovery in the second half of the week when our US Congress approved another $484B of small business stimulus. The big volatility this week was in oil prices – and specifically, a historic first when the US oil futures contract for May delivery of WTI crude oil temporarily sank to negative $37 per barrel.

Stocks and other investments can be perceived as financial abstractions, with a life and price fluctuation unto themselves. The reality is that they represent ownership in the future profits of real businesses and, in certain cases, real, physical commodities.

In the case of oil, the market is made up of traders as well as oil consumers, and if there is no demand for current oil production, it must be stored. The dramatic gap downward in price was driven by dwindling storage capacity in the US, which is in turn a reflection of dramatically lower current global demand – as well as an ill-timed political spat between Saudi Arabia and Russia.

This comes on the heels of global oil demand growing steadily every year since 2009, as well as parallel growth in various sources of renewable energy. It is an open question how energy demand will recover following the unique economic slowdown that is the coronavirus pandemic. While oil price issues will likely be resolved in the near term by reduced production, there is less visibility to what recovery of demand will look like.

To explain this week’s pricing collapse away as a technical phenomenon would be to miss the underlying issue: oil reserves are building because demand is depressed. For deliveries later in the year and in other parts of the world, where storage isn’t yet a problem, prices have still declined significantly. Brent Crude, the global oil benchmark, has declined by 70% so far this year – from $66/barrel in January to a meager $21.33/barrel currently.¹

Such low prices are a problem for producers, and the problem is particularly acute in the United States where shale oil production involves dramatically higher extraction costs than those required in Saudi Arabia or Russia. This crisis started in part with geopolitical gamesmanship, and those producers’ decision to increase global production when demand was already falling. Compounding this issue is the fact that many smaller US oil companies have substantive debt obligations that remain due; banks and debt obligations that aggravate their cash flow.

On the bright side, the coronavirus pandemic has provided a unique opportunity to see what radical reduction in carbon usage looks like for the environment. The graphs showing the incredible decline of air pollution feel almost like a parlor trick – but they are real. The data from this unexpected experiment will add a powerful element to the conversation about climate change, and to how and how quickly policy should support moving away from fossil fuels.

Economic analysis should include thoughtful consideration of all stakeholders, and while oil producers may struggle, low oil prices lead directly to prices for gasoline and other goods for which oil is a key input. Specific private and public businesses, including airlines or trucking companies, are further beneficiaries of low fuel prices. Low gasoline prices, and overall reduced travel costs are usually a positive for most US households.

For the moment, however, travelers are quarantined in their homes and many businesses are temporarily closed. This inability to benefit from low prices, therefore, means there are effectively no winners.

If low fossil fuel prices persist, they also make investment in renewable energy sources less economically compelling. When oil was over $100/barrel, it made sense for companies to invest in solar or wind energy. It helped the planet, and it helped profits. When oil is at $20/barrel, many public companies – who are confined to a shareholder model, rather than a stakeholder model – will make decisions based on short-term profitability rather than long-term sustainability.

In 2020, we are facing a dual crisis of an oil collapse and a global pandemic. The public policy responses of today will undoubtedly shape the future we move into – but, we also believe that investors have an important role to play in allocating capital to businesses that are building a sustainable future.

A post-oil future will be incremental. Renewable energy only represented 17.5% of electricity generation in the US in 2019.² That number moves lower when we factor in energy usage from autos and air travel that rely heavily on fossil fuels. Investors, however, have already begun voting with their dollars and bringing environmental, social, and governance (ESG) considerations to the foreground of public conversation and even corporate valuation.³

When a crisis hits the markets, investors immediately search for a historical analog. They postulate whether this will be a repeat of the 1987 crash, or a contagion event like 2008, or a virus pattern that mirrors the 1918 Spanish Flu. As humans we desperately seek patterns and insights that will ground our expectations and give us confidence to move forward. The current crisis has echoes of each of those past occurrences, and yet, is a unique event in a modern setting. It is also likely to provide a unique opportunity for investors to diversify their portfolios in a way that supports a path to economic and environmental sustainability.

That’s an exciting thought, and a real silver lining in today’s topsy-turvy markets.

¹ Closing price of upcoming contract, June 2020 Brent Crude, as of 4/23/20; per Bloomberg.

²U.S. electricity generation by energy source; https://www.eia.gov/tools/faqs/faq.php?id=427&t=3

³“Global sustainable investment now exceeds $30 trillion—up 68 percent since 2014 and tenfold since 2004.” Henisz, Witold, Tim Koller, and Robin Nuttall. “Five Ways That ESG Creates Value.” McKinsey Quarterly, November 2019.